We expect the current steel down cycle to last 2 years, shorter than previous down cycles, as global fiscal stimulus leads to a ‘V’ shaped global economy recovery. We expect profitability to nosedive in the near term and stabilize at lower levels.
Our channel checks reveal that demand will continue to be weak as consumers are afraid of restocking and maintaining inventory in a falling steel price environment.
We also believe that steel prices will remain under pressure in the near term as annual iron ore and coking coal contract prices are lowered in 2009.
At the current steel price, EBITDA margin will shrink to about $50/tonne for most steel companies in India as compared to more than $200/tonne margin in 2QFY09.
As fiscal measures affect demand and credit availability, we expect a gradual improvement in the steel industry fundamentals after September 2009.
We analyzed the historical steel business cycles in India and found that prices of steel stocks lead actual operating performance by two quarters.
Historically, steel stock prices start to trend upward at least two quarters in advance if investors perceive that EBITDA/tonne for steel companies will expand and vice-versa.
We estimate that EBITDA for steel companies in India will bottom out over 1HFY10 and believe that investors should consider entering Indian steel stocks around mid-2009.
While we expect stock prices of steel companies will drop in the near term, we see inherent value in steel companies as they are trading below their replacement costs and DCF based valuation.
The DCF valuations of SAIL and Tata Steel show 25%-50% under-valuation of these stocks in our base case scenario.
However, given the pessimism about the economy and steel demand in particular, fair price targets based on DCF valuation will be achieved over a 2-3 year timeframe.
We believe long-term investors will find buying opportunities over the next six months as stocks decline further to factor in near-term earnings risks.